1. Field of the Invention
This invention relates generally to the field of computer user interfaces, and more particularly to computer applications such as financial investments involving probabilistic distributions and the segmentation and aggregation thereof.
2. Background
Commonly used methods of constructing investment portfolios rely upon principles of the Capital Asset Pricing Model (CAPM). In 1990 the Nobel Prize in Economics was awarded to William Sharpe in recognition of his CAPM-related contributions. However, as with any theoretical construct, embedded within the CAPM are assumptions that serve to simplify the process of arriving at optimally structured portfolios. These simplifying assumptions have increasingly served to undermine the value of the CAPM over the more than four decades since the first ideas pertaining to the CAPM were introduced, and for a number of reasons including the rapid and ongoing evolution of capital markets generally and of statistical methods in particular. The theory's centerpiece of normally distributed returns has been increasingly brought into question, particularly with the proliferation of financial products and strategies specifically designed for generating non-Gaussian risk and return distributions. Concomitantly, thinly sliced segmentations of financial risk and return are now achievable, as is the computational ability to aggregate disparate statistical profiles. The speed and agility of personal computers today have also advanced well beyond the technical capabilities of even the most advanced computer systems of just a few years ago.
As to other limitations of the CAPM, from a more macro consideration the CAPM is designed to evaluate one investor profile at a time, thus rendering it of little value for situations where family, business, governmental, and/or other entities have collective interests with jointly defining an investment orientation. From a more micro perspective CAPM-generated probabilistic distributions do not make internal differentiations among potential segmentations of risk and return combinations. CAPM-distributions are formally characterized as an embodiment of “market risk and return”, yet this characterization can be misleading at best and detrimental to efficacious portfolio construction at worst. Perhaps a more meaningful description of CAPM distributions would be that they represent an embodiment of “financial risk and return”, where financial risk and return can embody market risk and return, credit risk and return, and structure risk and return. While there may be alternative terms to describe these risk and return prototypes, or even additional risk and return classifications that could be proposed, the essential point remains that risk and return can be segmented well beyond the simplistic all-encompassing “market risk and return” caricature of the CAPM.
As a commonplace practice today, investment counselors ask investors to describe their individual risk and return preferences in relation to rather broad product labels inclusive of “equities” or “bonds”. While these product classifications may have served a useful purpose at one point in time, today these labels can be misleading. With the advent and widespread acceptance of risky bond products (as with junk bonds, mezzanine debt, and perpetuals), it is an easy matter to identify bonds that are riskier than many equities, and to name equities that are less risky than even some U.S. Treasuries. At the same time, there has been tremendous growth in so-called absolute return and alternative investment funds, and these are often characterized by an objective of generating highly skewed non-normal returns. In sum, more relevant and meaningful risk and return designations are required for today's financial environment, and risk and return designations that can more readily and completely allow for a segmentation and aggregation of financial risks and returns. The present invention succeeds in these regards as follows:                1. The invention allows for a real time segmentation and aggregation of various financial risk and return probabilistic distributions. Further, these distributions may be segmented or aggregated for one or more investors within the context of a single aggregated risk and return profile.        2. Statistical profiles are not assumed or constrained to be Gaussian.        3. The catch-all role of “market risk and return” under a CAPM approach is instead differentiable into market risk and return, structure risk and return, and credit risk and return, and such that these and/or any other risk and return combinations may be isolated or not as per user preferences.        4. The invention may be applied as an input module to a process of creating optimal portfolios or for evaluating new or substitute features of an existing portfolio, and as an output module for a process that describes risk and return within already-existing portfolios.        
The present invention also has implications for quantitatively oriented combinatory processes related to risk and return assessments involving one or more products within or across asset classes. For example, the present invention may be of value with providing a meaningful summary of multiple equity analyst forecasts of a given stock so as to generate a single aggregated forecast that is meaningfully communicated to investors.
As to contemporary investment models, these are typically structured around considerations pertaining to an investor's age, financial goals, marital and family status, and so forth, and they generally rely upon some variation of a CAPM-type portfolio optimization tool. The present invention embraces an entirely different approach with the application of innovative techniques involving risk and return attributes of probability distributions linked to financial products. Within this context, an investor's risk and return preferences may be expressed in a greater variety of ways that go well beyond the CAPM's two-dimensional confines of mean and variance and related financial variables of sigma and beta.
The ability to effectuate the novelty of the invention's design, and the desirability of the invention's output, are appreciably enhanced by five factors:
First, recent advances with statistical and econometrical methodologies, particularly in the area of combinatory processes related to probabilistic distributions;
Second, the timely realization of investors that financial risks extend well beyond mere market risk to include credit risk as well as structure risk;
Third, the ability today to capture a variety of financial data that may be meaningfully collated for risk evaluation purposes;
Fourth, advances in the power and functionality of personal computers, and;
Fifth, the growth in the variety and availability of a diverse amount of traditional and non-traditional financial products inclusive of so-called hybrids and alternative investments.
The present invention is differentiated from existing financial investment tools in several ways. First, the invention permits a risk and return perspective that can extend well beyond a two-dimensional mean/variance profile of financial risk and return (where mean and variance are the first two moments of a probability distribution) to embrace a greater magnitude of substance and nuance via considerations of higher moments including, though not limited to, kurtosis and leptokurtosis. The more non-normal a distribution, the more valuable these higher moments become. Separately, a number of academic studies are now available that describe historically-used risk variables inclusive of beta and sigma as necessary though insufficient descriptors of actual risks borne by investors. Some of these studies go so far as to suggest that these traditional variables have become obsolete.
Second, unlike most contemporary models, the invention does not require an investor's personal financial data (income, age, savings, and so forth) to create a target portfolio, but rather translates an investor's expressed risk and return preferences into a target portfolio. Nonetheless, if an investor were to desire a forward-looking extrapolation of a portfolio generated by the present invention, and if he wanted to evaluate such an extrapolation on the basis of his personal financial data, this could easily be accomplished with the present invention. The invention may also be used to evaluate an already-existing portfolio relative to an investor's expressed risk and return appetite.
Third, the invention does not presumptuously impose its own pre-determined sense of appropriate investments on the basis of an investor's personal data, but rather focuses upon the investor's expressed risk and return preferences. While the present invention could most certainly be used in conjunction with existing so-called lifecycle investment models or CAPM-like optimization tools, a value of the present invention lies in its original orientation towards creating a successful marriage between an investor's risk and return objectives and the financial instruments that best satisfy those objectives.
Fourth, the invention does not rely upon traditional and increasingly outmoded financial labels to define risk and return profiles. As the markets have today reached a critical juncture whereby high yield (junk bond) securities may reflect greater price volatility relative to many equities, and some equities may have a lower price volatility relative to certain investment-grade debt, older label-oriented models are simply incapable of providing the same quality of output as the present invention.
The present invention may also be used in the context of aggregating expert opinions of an anticipated financial event or outcome. For example, in the context of the equity markets, it is often the case that a number of stock analysts will provide varied outlooks for the future price performance of a given company. The present invention readily provides a context for how those forecasts may be aggregated in a meaningful way, and with important non-obvious consequences for investment opportunities.
The present invention identifies three first-tier categories of financial risk and return, though an unlimited number of risk and return classifications are easily accommodated. The three first-tier categories of risk and return-types considered and defined herein include market risk and return, credit risk and return, and structure risk and return. A common thread across market, credit, and structure profiles is that each of these may be expressed in price terms, may be described with multiple moments, and may be aggregated into a single overall risk and return profile.
For present purposes, structure risk and return is defined as that portion of an asset's price behavior attributable to an asset's engineering. For example, and as is well known to those skilled in the art, a callable bond is engineered differently from a putable bond, and as such, ceteras paribas, these two instruments would not be expected to behave in symmetrical fashion in response to market or credit stimuli. This unique price behavior can be captured and cataloged accordingly under the heading of structure risk and return.
Credit risk and return is defined here as that portion of an asset's price behavior attributable to an asset's position within a particular issuer's capital structure. For example, the same company can be an issuer of both senior and subordinated debt, and at the same point in time. The senior debt would likely carry a credit rating superior to the subordinated debt, and perhaps for the simple reason that the senior debt affords an investor a more privileged recovery status in the event of the company's default. As a direct result of these asymmetrical credit protections, these instruments would not be expected to behave in a symmetrical fashion in response to a credit risk stimulus.
To quantify the market risk and return portion of an asset's price behavior, one approach might be to say that it simply comprises whatever portion of total financial risk and return that remains unexplained after quantifying the risk and return contributions of structure and credit. But if an asset's contribution to market risk and return were to be calculated and not inferred (perhaps leaving the contributions of credit or structure to be inferred), this could be accomplished with reference to an actual or synthetically pure market risk and return instrument. For example, the U.S. Treasury yield curve is commonly used as an embodiment of pure market risk and return for the bond market, thus providing a baseline for segmenting a non-Treasury instrument's market risk and return from its credit and structure components.
For purposes of the present invention, the manner of how market, credit, and structure can be categorized by risk and return profile is not as consequential as the fact that they can be meaningfully segmented. Further, the possibility that others may consider market, credit, or structure as non-first tier categories, or might seek a greater granularity of precision within any of these categories as with segmenting market risk and return into elements of liquidity, twist, roll-down, or any other terms of art, is also a tertiary matter relative to the fact that any of these measures are easily accommodated by the present invention.
Financial products can embody a variety of different investment vehicles. Although equities, bonds, and currencies may more commonly be regarded as financial products, other financial products might be said to include certain types of real estate transactions, commodities, antique collections, and so forth. The present invention does not exclude any type of investment vehicle, and the specific examples presented herein are not intended to be exhaustive in terms of either scope or applicability of the present invention.
As is well known by those skilled in the art, rating agencies exist whose primary function is to provide investors with guidance on the creditworthiness of companies, and generally in the form of a letter and/or number grade. Credit ratings exist for governments, businesses, and currencies, as well as for specific products. For example, a company may have one credit rating for its long-term bonds that differs from the credit rating on its short-term bonds. The rationale for this may be that near-term business prospects appear to be more favorable than longer-term prospects. While many investors believe credit risk to be of primary concern for bond investments, recent events involving such large corporations as Enron, Arthur Anderson, and others highlight how credit events can have a devastating impact on shareholders as well. Many academic studies are also now beginning to appear that demonstrate the presence of credit risk premia in equities.
At the same time that lines are being blurred across asset classes as with junk bonds and equities, distinctions among products within asset classes are growing more complex. In the context of equities, there is common stock and preferred stock. Although holders of preferred stock generally do not have identical voting rights of common stock investors, preferred stock typically pays a fixed dividend whereas common stock may pay a fluctuating dividend or no dividend at all. Preferred shareholders have a more senior status to common stock holders in the event of liquidation, and for this reason common equity is sometimes called junior equity. Different types of preferred shares include, though are not limited to, cumulative, non-cumulative, participating, and convertible. Preferred stock may also come with warrants attached, or may be callable. Preferred shares may be ranked in seniority (as in first versus second preferred shares) or have dividend payments guaranteed by a third party, though these considerations are perhaps more properly designated as credit-related phenomena rather than strictly structure-related. While a single company usually issues one type of common stock, it may have several different types of preferred stock outstanding at any point in time.
In the context of bonds, debt may be structured as a debenture or pass-through, with a coupon or without, as a callable or putable, extendible or retractable, convertible or exchangeable, secured or unsecured, and with or without a considerable number of other features. A single company may have many different types of debt outstanding at any one point in time.
The preceding descriptors of equities and bonds are not intended to be exhaustive, nor are the product-types cited here to be definitively construed as being within the exclusive domain of “equities” or “bonds”. For example, many financial professionals regard preferred shares as being more bond-like than equity-like owing to their fixed dividends (akin to coupons) and stated maturity dates. Other financial professionals are of an opposite view stemming from the junior credit standing of preferreds. Even within the context of commonly used market indexes, differences of product inclusion arise. For example, while the S&P 500 index is comprised exclusively of common stock, the Wilshire 5000 index is comprised of common stock, preferred shares, real estate investment trusts (REITs), and limited partnerships. In sum, as financial products increasingly defy simple categorization by traditional methods, a non-traditional approach is required, and the present invention offers a unique software-based solution.